Saturday, September 6, 2008

Government Takeover of Fannie and Freddie

Don't underestimate the importance of this news story. As technical as it sounds, the US Treasury Department's seizure of the "Government Sponsored Entitities" (GSEs) Fannie Mae and Freddie Mac (for a basic primer on these institutions, see here) is important and has profound implications:

According to the Times, "It is not possible to calculate the cost of any government bailout, but the huge potential liabilities of the companies could cost taxpayers tens of billions of dollars and make any rescue among the largest in the nation’s history."
What's worse, we can't say we weren't warned.

This is perhaps the most disturbing aspect of this story. For years, various experts have told anyone who would listen that Fannie and Freddie were in urgent need of reform.

"The strong belief of investors in the implicit government backing of the GSEs
does not by itself create problems of safety and soundness for the GSEs but
it does create systemic risks for the U.S. financial system as the GSEs
become very large," he said.

there is reason to be seriously concerned about potential future social costs associated with the systemic risk emanating from Fannie Mae and Freddie Mac and that this risk largely arises from the institutions’ highly leveraged investment portfolios. We also find the social benefits of these portfolios to be minimal to non-existent. From these considerations, we conclude that a large reduction in the size of these portfolios would be socially desirable.
Some in Congress, however, was having none of it.
Here's Congressman Reuben Hinojosa:
I continue to support the level of Fannie Mae’s portfolio of loans. I disagreed
one hundred percent with former Federal Reserve Chairman Alan Greenspan’s
recommended that Fannie Mae’s portfolio be reduced from its current level to one
hundred billion dollars worth of loans. Such a proposal would have negatively
impacted Fannie Mae’s ability to meet its mission and would have harmed my

And Representative Paul Kanjorski:
I am also heartened that Fannie Mae, according to its regulator, is cooperating and working to address these issues in a responsible manner. I am also pleased that although serious, these problems do not appear to pose a systemic risk according to those most knowledgeable of the facts in these matters.
I don't mean to single these two Members of Congress out. There were plenty of Members who turned a blind eye to need to rein in Freddie and Fannie.

So, Congress failed to act despite being warned by the most prominent financial experts in the nation. The taxpayers will pick up the tab. When Members of Congress ignore people like Alan Greenspan and housing finance experts, we need to ask "why?"

Amazingly, these entities were allowed to lobby even though they enjoyed explicit and implicit government subsidies. They spent millions on lavish fundraisers, employed many lobbyists both in house and the best K Street had to offer. This may serve as a partial explanation. Further, rather than being run by experience bankers, Fannie was run for many years by former politicos such as James Johnson, a former aid to Walter Mondale. Fannie hired many top staff from both parties for top jobs that any sane financial institution would have reserved for MBAs. They were political animals, yet they played with real money - taxpayers' money it turns out.

This why the Shadow Financial Committee, a non-partisan group of academics and other experts convened by the American Enterprise Instiute recommended back in 2005:

Congress should adopt a number of additional provisions that will reduce the impression among investors that Fannie and Freddie are backed by the government. Thus, Congress should repeal their exemption from state and local taxes, their so-called line of credit at the Treasury, the authority for national banks to make unlimited investments in their securities, and the fact that their securities may be used to collateralize Treasury's deposits in banks. In addition, as appropriate for organizations that receive a government subsidy, the GSEs should be prohibited from making political contributions and their lobbying activities should be limited.

These quasi private, private government entities, which allow people to real private sector like benefits while exercising government like power have been disasters. Why Fannie and Freddie failed, and why Members of Congress blocked reform legislation, should be thoroughly investigated. We could find a story that would make the whole Jack Abraham story appear to be trivial.

No comments: